ABSTRACT
Banking operations worldwide have undergone phenomenal changes in the
last two decades since 1990s. Financial liberalization and technological
innovations have created new and complex financial instruments/products
have increased their role and turnover in financial markets and have
rendered banking operations vulnerable to a variety of risks. The financial
crisis episodes surfaced since 2006 have highlighted this paradox to a
number of central banks operating in different countries and RBI and Indian
banking sector is no exception to this phenomenon. Basel framework has
been drawn by Bank for International Settlements (BIS) in consultation with
supervisory authorities of banking sector in fifteen emerging market
countries with the basic objective of advocating codes of bank supervision
and promoting financial stability amidst economic crises.
This research paper is divided in three parts .The opening part attempts to
briefly describe the changes in the banking scenario since 1991 reforms and
the necessity of introducing Basel III to the Indian Banking sector. Part II
presents the Basel standards framework and explains why the transition
from Basel II to Basel III norms has become necessary to bring in measures
and safety standards which would equip the banks to become more resilient
during the financial crises and prevent the banks being subject to
liquidations /closures. Part III brings out a discussion on the compliance
process by the Indian banks to Basel standards in recent period and finally,
the issues and challenges faced by the Indian Banking sector are posed in
the conclusion.
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reforms resulted in comprehensive transformation of the banking sector in the economy. The
reforms had a major impact on the overall efficiency and stability of the banking system.
The outreach of banks increased in terms of branch /ATM presence geographically across
the country and segments of the population. The balance sheets and the overall banking
activities combined with financial and investment banking services grew in size and scope.
The financial performance and efficiency of Indian banks improved dramatically with
increased competition between public sector banks and new generation technology oriented
private banks. This could be observed in the profitability, net interest margins, return on
assets (ROA) and return on equities. (ROE) The capital position improved significantly and
the banks were able to bring down their non performing assets (NPA) sharply. This reform
phase also revealed increased use of technology which in turn helped improve customer
service.
While financial stability is not explicitly stated objective under the Reserve Bank Act 1934,
various measures were undertaken from time to time to strengthen the financial stability in
the system which covered a wide arena. The approach has evolved from past experiences and
a constant interaction between the micro level supervisory processes and macroeconomic
assessments. In the Indian context, the multiple indicator approach to monetary policy as
well as prudent financial sector management together with a synergetic approach though
close Coordination between RBI and other financial sector regulators has ensured financial
stability. Some of the other policy measures include capital account management,
management of systemic interconnectedness, strengthening the prudential framework,
initiatives for improving and broadening the financial marketing infrastructure and a host of
other measures. Systemic issues arising out of interconnectedness among banks and between
banks and non banking financial companies (NBFCs) and from common exposures were
addressed by prudential limits on aggregate interbank liabilities as a proportion of banks net
worth, restricting access to uncollateralized funding market to banks and primary dealers
with caps on both borrowing and lending, increasingly subjecting NBFCs to contain
regulatory arbitrage. The other noticeable aspect regarding policy measures has been the
innovative use of countercyclical policies to address the pro-cyclicality issues. The counter
cyclical policies were introduced as early as 2004 by using time varying sectoral risk
weights and provisioning, though RBI had used them sporadically even earlier. These
unconventional measures taken in response to emerging risks are now widely acknowledged
to have played a significant role in protecting the Indian Financial system from key
vulnerabilities.
Basel standards Framework
Generally, the adoption of Basel standards is to be viewed in the context of regulatory
approach to bank supervision by the central bank of the country and the incentives system
for the banks to improve their risk measurement procedures. It also takes cognizance of the
fact that the new technological innovations in information technology have revolutionized
the banking operations and the market practices have altered substantially since the
introductory period of Basel standards .Consequently, Basel standards envisage a change in
the oversight function of the central bank as a regulatory body over the commercial banks
operating in the country and the capital adequacy requirements of the banks.
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Rapid transformation of financial system around the globe has brought sweeping changes in
the banking sector across the countries. Though new avenues and opportunities have been
opened up for augmenting the revenue generation for banks, yet new processes and
technological progress has exposed the banks to higher risk. Therefore, the need was felt
for strengthening the soundness and stability of banks and to protect the depositors and the
financial system from disastrous developments which could threaten the banks solvency.
Basel Committee on Banking Supervision (BCBS) under the auspices of Bank for
International Settlements (BIS) took initiative putting in place adequate safeguards against
bank failure with central banks across the globe.
The first initiative from BIS can be identified with Basel I Accord with over 100 central
banks in different countries accepting the framework stipulated by agreement. The accord
provided a framework for fair and reasonable degree of consistency in the capital standards
in different countries, on a shared definition of capital. Although these standards were not
legally binding, they have made substantial and significant impact on banking supervision in
general, and bank capital provisioning and adequacy in particular. However, Basel I
comprised of some rigidities, as it did not discriminate between different levels of risks. As a
result, a loan to an established corporate borrower was considered as risky as a loan to a new
business. .So all loans given to corporate borrowers were subject to the same capital
requirements, without taking into account the ability of the counterparties to repay. It also
did not take cognizance of the credit rating, credit history and corporate governance structure
of all corporate borrowers. Moreover, it did not adequately address the risk involved in
increasing the use of financial innovations like securitization of assets and derivatives and
credit risk inherent in these developments. The important category of risk i.e., operational
risk also was not given the attention it deserved.
Basel II-The New Capital Adequacy Framework
Recognizing the need for a more comprehensive, broad based and flexible framework , Basel
committee proposed an improved version in 1999, which provides for better alignment of
regulatory capital with underlying risk and also addresses the risk arising from financial
innovation thereby contributing to enhanced risk management and control. This sophisticated
and superior framework was formally endorsed by central bank governors and heads of
banking supervisory authorities of various countries on June 26, 2004 under the name
International Convergence of Capital Measurement and Capital Standards popularly
known as Basel II or New Basel Capital Accord. This new set of international standards
requires banks to maintain minimum level of capital, to ensure that they can meet their
obligations, cover unexpected losses and improve public confidence. Basel II captures the
risk on a consolidated basis for internationally active banks and attempts to ensure that
capital recognized, set aside in capital adequacy measures and provide adequate protection to
depositors. It brings into focus the contemporary risk management techniques and seeks to
establish a more risk responsive linkage between the bank operations and their capital
requirements. It also provides strong incentive to banks to upgrade their risk management
standards. The accord is a cornerstone of the current international financial architecture. Its
overriding goal is to promote safety and soundness in the international financial system. The
provisioning of adequate capital cushion is central to this goal and the committee ensures
that new framework maintains the overall level of capital currently in the banking system.
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The advocates of Basel II believe that creating such an international standard can help to
protect the international financial system from various types of financial and operational
risks that banks may encounter. It also attempts to set up such rigorous risk and capital
management requirements to ensure that banks hold sufficient capital reserves appropriate to
the risk the bank exposes itself through its lending and investment activities.
The objectives of the new Basel accord as enunciated by BIS are fivefold:
1. Promoting safety and soundness of financial system
2. Enhance competitive equality
3. Greater sensitivity to the degree of risk involved in banking positions ,activities
4. Constitute a more comprehensive approach to addressing risk and
Focus on internationally active banks, with capability of being applicable the banks with
varying level of complexity and supervision.
Structure of Basel II
Pillar I
Minimum Capital
Requirement
Pillar II
Supervisory Review
Process
Pillar III
Market Discipline
The structure of Basel II framework has its foundation on three mutually reinforcing pillars
(as shown in the above diagram ) that allow banks and bank supervisors to evaluate properly
the various risks that banks face and realign regulatory capital more closely with inherent
risks . These three pillars are discussed as under:
Pillar I: Minimum Capital requirement
The first pillar of Basel II deals with maintenance of regulatory capital, i.e. minimum capital
required by banks as per their risk profile. As in Basel I, Basel II also has same provisions
relating to regulatory capital requirements i.e. 8 % Capital Adequacy Ratio (CAR). CAR
under Basel II is the ratio of Regulatory Capital to risk weighted assets which signifies the
amount of regulatory capital to be maintained by banks to guard against various risks
inherent in banking system.
Capital Adequacy Ratio =
The risks covered under CAR in Basel II are credit risk, market risk and operational risk
.Pillar I focuses on new approaches for calculating minimum capital requirements under
credit risk, market risk and operational risk vary from simple to sophisticated and allow bank
supervisors to choose an approach that seems most appropriate according to their risk
profile, activities and internal control.
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exchange reserves to fight against the attack of the countrys currency. Therefore ,Asia and
in particular ,China and some other emerging economies produced goods at a cheaper rate
and pursued a policy of export- led growth and accumulated huge foreign exchange reserves.
As a corollary, the USA and Europe consumed that produce and became net importers .The
foreign exchange reserves accumulated by Asian and other emerging economies were
necessarily to be invested in advanced economies which have deep markets. The huge
amount of capital that flowed from the emerging economies, depressed yields in the financial
markets of advanced economies. In the search of yield to improve returns on investment
market players indulged in financial innovation and engineering. They developed structured
financial products like securitization and re-securitization based on sub-prime mortgage
backed securities (MBS), collateralized debt obligations (CDOs) and CDO squared etc.
Credit default swaps (CDS) were also used to create synthetic structures which increased
their illiquidity and complexity. Without realizing the inherent risks created by these
features, securitizations continued to grow leaps and bounds leading to the spiraling of subprime lending with impending disastrous consequences.
At the micro level, the business models of banks and financial institutions also were causal
to the crisis. The over reliance on financial innovation /securitization type instruments did
not create any incentive for banks to better appraisal and supervision of such mortgages.
Their reliance on wholesale funding markets created gaps in liquidity risk management.
Short term funds were used for creating long term assets. The availability of plenty and
cheap funds encouraged banks to be highly leveraged, that too, by borrowing short term
funds. The crisis has also been attributed to the inadequate corporate governance and
inappropriate compensation system for senior management in the banks.
Basel III :Post crisis, the global initiatives to strengthen the financial regulatory system are
driven by the leadership of G 20 under the auspices of Financial Stability Board (FSB) and
the Basel Committee on Banking Supervision (BCBS) .Immediately after the crisis, the
Basel Committee , in July 2009 came out with certain measures also called enhancement to
Basel II or Basel II.5 to plug the loopholes in its capital rules ,which were exploited to
arbitrage capital by parking certain banking book positions in the trading book which
required less capital . The Basel committee published its Basel III rules in December 2010.
Learning the lessons from the crisis, the objectives of Basel III have been to minimize the
probability of recurrence of a crisis of such magnitude. Towards this end, the Basel III has
set its objectives to improve the shock absorbing capacity of each and every individual bank
as the first order of defence and in the worst case scenario, if it is inevitable that one or a few
banks to fail . Basel III has measures to ensure that the banking system as a whole does not
crumble and its spill-over impact on the real economy is minimized. Basel III has in effect,
some micro prudential elements so that risk is contained in each individual institution and
macro prudential overlay that will lean against the wind to take care of issues relating to the
systemic crisis. The Basel III framework sets out higher and better quality capital, enhanced
risk coverage, the introduction of a leverage ratio as a back-stop to the risk-based
requirement, measures to promote the buildup of capital that can be drawn down in times of
stress and the introduction of compliance to global liquidity standards. The following charts
explain the various components of Basel III:
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High
Market risk
Controllable
risks
Credit risk
Controllability depends on
measurement developments and
the development of markets
Operational risk
Strategic risk
Low
NonControllable
risks
Legal risk
Low
High
A Cognitive Mapping of Risks can be drawn as above, to illustrate the extent to which the
various risks which are faced by the banks can be classified. Risk management in banks has
been gaining ground for last two decades and the financial crisis of 2008 has led to persistent
calls for experienced full time oversight on enterprise wide risks as described. All banks are
now required to have an internal department directly reporting to the Chief Executive officer
and Managing Director for the Risk management activity.
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As explained above, the key elements in Basel III include the following:
1. The definition of capital made more stringent, capital buffers introduced, and loss
absorptive capacity of Tier I and Tier II capital instrument of internationally active
banks proposed to be enhanced
2. Forward looking provisioning prescribed
3. Modifications made in counterparty credit risk weights
4. New parameter of leverage ratio introduced
5. Global liquidity standard prescribed
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The proposed Basel III guidelines seek to enhance the minimum core capital (after stringent
deductions) introduce a capital conservation buffer (with defined triggers) and prescribe a
countercyclical buffer (to be built in times of excessive credit growth at the national level)
Capital Conservation buffer The Basel Committee suggests that a new buffer of 2.5 % of
risk weighted assets (RWA) over the minimum capital requirement of core capital
requirement of 4.5 % be created by banks. Although the Committee does not view the
capital conservation buffer as the new minimum standard , considering the restrictions
imposed on banks and also because of the reputation issues, 7 % is likely become the new
minimum capital requirement.
The main purpose of the proposed capital conservation buffer is two-fold:
1. It can be dipped into in times of stress to meet the minimum regulatory requirement
on core capital
2. Once accessed, certain triggers would get activated ,conserving the internally
generated capital .This would happen as in this scenario ,the bank would be
restrained in using its earnings to make the discretionary payouts (e.g. dividends,
share buybacks and discretionary bonus)
Countercyclical buffer The Basel committee has suggested a countercyclical buffer
constituting of equity or fully loss absorbing capital could be fixed by the Central bank upon
the constituent commercial banks once a year , and the buffer could range from 0 to 2.5 % of
RWA depending on the changes in credit to GDP ratio. The primary objective of having the
Counter cyclical buffer is to protect the banking sector from system wide risks arising out of
excessive aggregate credit growth. This could be achieved through a pro cyclical build up of
the buffer in good times. Typically, excessive credit growth could lead to the requirement for
building up a higher countercyclical buffer; however the requirement could reduce in times
of stress, thereby releasing the capital for absorption of losses or for protection of banks
against the impact of potential problems.
The Compliance process of Indian Banks to Basel III
The minimum capital for common equity, the highest form of loss absorbing capital, will be
raised from the current 2% level, before the application of regulatory adjustments to 4.5%,
after the application of regulatory adjustments. This increase will be phased in to apply from
Jan 1, 2013. In addition to the above, the committee recommended a 2.5% of additional core
equity capital as a conservation buffer above the regulatory minimum taking the aggregate
minimum core equity required to 7%. The conservation buffer is also phased in to apply
from Jan 1, 2016 and will come into full effect from Jan 1, 2017.
Certain regulatory deductions (material holdings, deferred tax assets, mortgage servicing
rights etc) that are currently applied to tier 1 capital and/or tier 2 capital or treated as RWA
will now be deducted from Core equity capital. This will also be progressively phased in
over a five year period commencing 2014.
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Phasing-in effect:
Minimum core
equity
Conservation
buffer
Total core
equity
Min. total
capital incl.
buffer
Phasing in of
other
deductions
from core T1
Counter
cyclical buffer
2013
3.5%
2014
4.0%
2015
4.5%
2016
4.5%
2017
4.5%
2018
4.5%
2019
4.5%
.625%
1.25%
1.875%
2.5%
3.5%
4.0%
4.5%
5.125%
5.75%
6.375%
7.0%
8.0%
8.0%
8.0%
8.625%
9.25%
9.875%
10.5%
20%
40%
60%
80%
100%
100%
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on these aspects is not disclosed by the banks for reasons citing confidentiality or
competitiveness.
The link between nonperforming assets (NPA) capital adequacy and provisioning is
well known to be highlighted here. The challenge is to provide incentives for banks
/financial institutions to recognize losses on account of NPAs as per Basel norms.
More than four years after the financial crisis began, it is so widely accepted that
many of the worlds banks are burying /hiding losses and overstating their asset
values ,even the BIS is saying so- in writing. It fully expects the taxpayers to pick
up the tab should the need arise, too.
The lack of transparency, credibility in banks balance sheet fuels a vicious circle.
When investors cannot trust the books, lenders cant raise capital and may have to
fall back on their home countries governments for help. This further pressures
sovereign finances, which in turn, weaken the banks even more. The adage too big
to fail does not easily become applicable to banks often as the size of the banks
capital, operations, NPA, provisioning increases. This issue needs separate
discussion as the challenge is greater and real.
Finally, it is significant to note that new and private sector banks, with their high
capital adequacy ratios, enhanced proportion of common equity and better IT and
other modern financial skills of the personnel, are well placed to comply with Basel
III norms in general. PSU banks although dominant banks in the Indian financial
system may take more time and face challenges in following the Basel III guidelines.
REFERENCES
1. Anand Sinha : Indian Banking Journey into the Future , RBI monthly Bulletin
February 2012
2. Anette Mikes :Counting Risk to Making Risk Count Harvard Business School
Working Paper ,March 2011
3. Bank for International Settlements (BIS): Basel III Accord: the New Basel III
Framework, BIS, December 2010.
4. K.C.Chakrabarty: Indian Banking Sector: Towards the next orbit, RBI Monthly Bulletin,
March 2012.
5. ICRA Comment : Proposed Basel III guidelines : A Credit positive for Indian Banks
ICRA Limited ,2010
6. K.C. Shekhar and Lekshmy Shekhar : Banking :Theory and Practice (20th Edition )
Vikas Publishing House Pvt.Ltd. 2011
7. B.Mahapatra: Implications for Basel III for Capital, Liquidity and Profitability of Banks,
RBI Monthly Bulletin, April 2012.
8. Mandeep Kaur and Samriti Kapoor : Basel II in India :Compliance and Challenges
Management and Labour Studies, Vol.36, No.4, November 2011
9. Dr.K.Revathi : Basel III :Toning up the Banks Strength , Facts for you , April 2012
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10. Several articles and news items from Financial Express, Business Standard and
Economic Times.
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